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Living off the Income

I recently had a conversation with a family member who’s nearing retirement. When I asked what withdrawal rate he was planning to use, he explained that his plan was to “live off the income” of his portfolio so that he doesn’t have to worry about running out.

People say that a lot, and it certainly can be a good plan. But the plan’s probability of success depends a lot upon how it’s implemented. Specifically, it makes a big difference whether you plan to:

  1. literally live off the income (that is, only spend the dividends and interest earned each year),
  2. live off an estimate of the average income (e.g., each year, withdraw 3% of what your portfolio was worth on the day you retired–based on the assumption that the portfolio should generate an average income of 3% per year), or
  3. live off an estimate of the total expected return for the portfolio (e.g., withdraw 6% each year on the assumption that the portfolio’s total return will average out to 6% per year).

Plan #1: Spend only the Income

If you spend only the dividends and interest from your holdings, you obviously won’t run out of money. Unfortunately, this plan isn’t feasible for most investors because:

  1. It can involve significant fluctuations in income from year to year,
  2. It requires you to have a very large portfolio, and
  3. The income might not keep up with inflation.

Plan #2: Spend Based on Expected Portfolio Income

If you base your spending upon an estimate of the income you expect your portfolio to generate, you eliminate the difficulties caused by having an unsteady income. The catch, of course, is that you expose yourself to the possibility of running out of money should your portfolio’s earnings end up below your estimate.

And you’ll still need a very large portfolio.

Plan #3: Spend Based on Expected Total Return

If your plan is to withdraw money based on the total return you expect your portfolio to earn, then you’re likely in trouble.

First, as with plan #2, the portfolio might not earn what you expect.

Second, volatility will be a problem. For example, if the funds in which you’re invested earn an effective annual return of 8% over the 30 years of your retirement, and each year you withdraw 8% of your portfolio’s at-retirement value, you’re taking a serious risk of running out of money.

Why? Because the funds didn’t earn 8% each year. If the bad years come first, you’re up a creek.

Adjusting for Inflation

Since plans #2 and #3 are just guesses anyway, you can always build an inflation adjustment into the guess. (Something along the lines of “withdraw 3% of the portfolio value in the first year, then adjust the withdrawal amount upward each year based on inflation.”)

Of course, such adjustments don’t actually increase your probability of success. All they do is increase the rate at which you draw down your portfolio, effectively obtaining a higher standard of living now in exchange for a greater risk of running out of money later.

Said differently, building an inflation adjustment into your withdrawal plan makes sure your standard of living doesn’t decline…right up until the (possible) point where it does.

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Comments

  1. Why not use a portion for some sort of annuity? Yes I know the standard response concerning their expenses, but you are shifting your risk and you are guaranteed (as long as the insurance company survives) a set income – which may have COLA built in.

    What are your thoughts? Do you completely dismiss them? do you think they are part of an overall plan?

  2. I’ve been considering taking a conservative fixed amount (say 2-3%) to cover living expenses then in good years give myself a bonus of some fraction of the real returns. That way may spending should tack my portfolio performance, but never be so low that I can’t live resonably. I also think it would be good to have 3 years of living expenses in something very conservative so that if there is a large market crash I can ride it out without having to sell. Unfortunately, it does require a depressingly large nest egg!

    @Evin

    I think an immediate annuity (and social security benefits if they still exist!) should be a consideration for a portion of a portfolio, you could consider it a hedge against living really long. However, I wouldn’t put too much under any one policy- I believe states only cover insurance to about $100K, so any more than that you risk the insurance company going broke!

    -Rick Francis

  3. In your post you note what doesn’t work … what are your suggestions for what would work? Would significant cash reserves help? Thanks.

  4. I definitely don’t dismiss annuities. A low-cost, single premium immediate fixed annuity can be a great way to increase one’s “safe withdrawal rate” (assuming, obviously, that the investor is OK with giving up the possibility to leave something to heirs).

  5. As to cash reserves, I’d say that, yes, a portion of one’s portfolio in retirement should be in cash/money markets/CDs.

    My point isn’t that each of the three methods won’t work. My own recommended method is basically plan #2 above, including an inflation adjustment. (In other words, withdraw x% of the portfolio in year #1, then adjust that withdrawal amount upward each year in accordance with inflation.)

    How big the “x%” should be is a tricky question. Many people say 4%, but I think that’s too high for the myriad of investors who plan to retire earlier than 65 or so. (Though as Evan mentioned above, a single premium fixed annuity can be used to help increase one’s safe withdrawal rate.)

  6. “I’ve been considering taking a conservative fixed amount (say 2-3%) to cover living expenses then in good years give myself a bonus of some fraction of the real returns.”

    I like that. To the extent that you’re able to live off a variable income, it certainly helps reduce the likelihood of running out of money.

  7. Mike writes: “As to cash reserves, I’d say that, yes, a portion of one’s portfolio in retirement should be in cash/money markets/CDs.”

    But how large a portion, and by when should one start moving money into these safer vehicles? I am about 4-5 years from retirement, and still maintain about a 60/40 stock/bond ratio. Am I too aggressive now, and should I start building up the bond percentage or putting more into a money market?

    “(Though as Evan mentioned above, a single premium fixed annuity can be used to help increase one’s safe withdrawal rate.)”

    When should one buy such an annuity? And how much of the portfolio should be put into the annuity?

    I would also like your reaction to the point of view outlined here:

    http://www.nytimes.com/2009/08/29/your-money/individual-retirement-account-iras/29money.html

  8. All financial plans are estimates and playing the long-term financial odds of historical returns. The general rule of thumb is to plan for a 4 – 5 % withdrawal rate each year. Anything above that puts a person at risk of running out of money in their retirement years. It assumes that on average your portfolio will earn enough to replace what you withdraw each year.

  9. Any money I’d expect to spend in the next 3 years or so, I’d probably have in cash/CDs.

    Regarding how much of the portfolio should go into an annuity, that depends on the withdrawal rate that you need in order to fund your expenses. (The higher your necessary withdrawal rate, the more should be in an annuity.)

    As to when to buy the annuity, that’s a question I’m still working on myself. (Specifically: Does it depend only on age? Or does it also vary as a function of current yields on TIPS as well as market valuation levels.)

    Regarding the NYT article: Yes, PE 10 has been shown to have reasonably meaningful predictive power. Personally though, if I were to put PE 10 to use, I’d be more inclined to use it to adjust asset allocation within a given range than to use it to determine withdrawal rates.

  10. Mike says, “Any money I’d expect to spend in the next 3 years or so, I’d probably have in cash/CDs.”

    Do you feel this should be kept in the retirement portfolio or does it matter? Example: say I have $600,000 in retirement, $20,000 in after-tax FDIC-ensured cash, and expect $20,000 a year in Social Security if I claim benefits starting at 66. In today’s dollars, I need another $15,000 after tax to live and I expect to pay 25% federal+state. (These are not my actual numbers, but that’s besides the point.) Let’s say I keep $60,000 of the portfolio in the money market fund, which gives me about 3 years plus money for taxes. Just as a ballpark estimate if you could: Do I have enough saved so that I don’t run out of money in 25-30 years? will a 4-5% withdrawal rate let me meet my goal or do I have to either scale back or save more? Thanks.

  11. This plan has been more popular with UK investors over the years, perhaps because we never gave up entirely on dividends like US investors seem to have.

    I’ve written a bit on my site about the method, which is basically to either buy and potentially manage a portfolio of higher yielding shares (I say potentially manage because there is some thought you’re best off leaving well alone once you’ve bought the shares – long story) or else buy something like closed end investment trusts that pay a high income (possibly by using gearing or similar).

    With patience as to when you buy it’s very possible to generate an income of around 5% pa from pretty big UK stocks or trusts, with theoretically the prospect of inflation beating income growth.

    I say potentially because the whole method has been severely challenged by the dividend cuts of the past two years, which were much deeper than the UK market usually experiences (especially as because stalwarts like banks blew up).

    One safety net is a margin of safety on your initial income, which you reinvest when years it isn’t needed, to hopefully build a big portfolio ahead of years where it is. Cash and/or bonds and/or annuities can also be used. (The investment trusts I mentioned frequently hold reserves, too, to make up for bad income years).

    I plan to follow something like this method, partly because I like how once you’ve got the (admittedly as you say) big portfolio required, you can effectively switch on and off living off it without doing anything!

    Hmm, long rambling comment. Should probably have done a post and linked instead! 😉

  12. You bring up a good point. To retire and live to 100 you will need a lot of money saved. Start early and invest it wisely.

  13. “Do you feel this should be kept in the retirement portfolio or does it matter?”

    Are you asking about the most efficient place to keep cash holdings? Or are you asking whether cash holdings should be included for purposes of calculating your overall asset allocation and withdrawal rates?

    If the second question is what you’re asking, I’d say “yes, consider cash balances to be part of your portfolio.”

    As to safe withdrawal rates, I’m reluctant to go much over 4% if the plan is to take withdrawals for 30 years (if we’re assuming no annuitizing–more posts on that topic coming soon). However, from the numbers you quoted, withdrawing $20k per year from a $600k portfolio would only be a 3.33% withdrawal rate.

  14. Susan Tiner says:

    I like the method of annually withdrawing 4% of the current balance, with 3-5 yrs cash/fixed income reserves. This did involve drastic budget cuts in 2009, but a refund of 2008 estimated taxes plus essentially no taxes in 2009 helped considerably. It’s good practice to know how to cut back when necessary. It also helps to have a part-time business and a HELOC as backup sources of income/cash.

  15. I suppose I started by asking the first question, but transitioned into asking the second. But what confuses me about your answer (and in general, discussions of this type) is that the 3-4% rate seems to assume the value of the portfolio is static – whereas I would think that even if one is withdrawing and no longer contributing, the portfolio over time, the longer the better, still could increase in value just based on its own internal earnings. (And it could also decrease in value due to market fluctuations, at least temporarily, or lose value from inflation.)

    That said, I would like to know the best place to keep cash as well, especially at a time when interest rates are minimal.

  16. Debbie M says:

    I plan to take 4-5% per year. Rather than increasing the original amount for inflation each year, I will take 4-5% of the actual value of the portfolio each year. This will lead to large fluctuations. In those years when I get more money than I need, I’ll put the extra into cash savings. In those years when I don’t get enough, I will pull some from savings. I plan to start with about six month’s worth of expenses in cash (probably a CD ladder)–a bit more if the market seems to be in a bubble and a bit less if everything just plummeted.

    Disclaimer – I have a pension that will cover all my expenses at first. Otherwise I would probably plan to have two years worth of expenses (+ or – one year, based on market conditions) saved in cash.

  17. For those of you withdrawing 4% of your balance, would you do so as an annual lump sum or periodically through the year such as monthly? Considering the performance of the market in 2009, this is not just an academic question!

  18. Susan Tiner says:

    I take it in quarterly chunks throughout the year, adjusting the 4% to whatever the balance is that quarter. Like Debbie M, I’ll save funds during the fat years so there’s reserves during the lean years. But I also cut back on spending during lean years.

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